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How Peter Lynch Destroyed the Market

Reflect on his record for a second. Lynch ran Fidelity's Magellan Fund from 1977 to 1990, beating the S&P 500 in all but two of those years. He averaged annual returns of 29%. That's a mind-blowing figure. It means that $1 grew to more than $27; if you invested as little as $37,000 with him in 1977, you were a millionaire in 1990.

Fortunately for us, he's willing to share his secrets. To achieve his stunning track record, he clung to eight simple principles. Here they are.

1. Know what you ownSeems elementary, right? But as someone who talks to lots of investors, I can report that you'd be shocked at how few investors actually do their research. Scroll down to No. 7 for a good first step in getting ahead of the game.

2. It's futile to predict the economy and interest rates (so don't waste time trying)After 2008's crash, I noticed a distinct increase in armchair economists. We financial types do enjoy water cooler talk about interest rates, trade deficits, debt levels, etc. But there's a danger in converting thought into action.

The U.S. economy is an extraordinarily complex system, with 300 million people acting in their own self-interest and responding to each others' actions, government incentives, and external shocks. And that's before we factor in our increasingly frequent interactions with the rest of the world.

Trying to time the market is futile. Set up a financial plan that allocates your assets based on your risk tolerance, so that you can sleep at night.

3. You have plenty of time to identify and recognize exceptional companiesLynch mentions that Wal-Mart (NYSE: WMT) was a 10-bagger -- i.e. its stock rose to 10 times its initial price -- 10 years after it went public. Even if you had gotten in after waiting a decade, though, you'd be sitting on a 100-bagger.

Some would argue that it's still not too late to get in on Wal-Mart, decades after going public. While the company's no longer a monster growth story, it continues to crank out 20% returns on equity year after year. That type of consistent ROE is a huge positive indicator of management's ability to effectively allocate capital.

I could tell a similar tale about Microsoft's early growth years, right on down to its still-impressive current return on equity (42%).

And Amazon.com (Nasdaq: AMZN) , though only 13 years old as a public company, has seen its stock double since its 10th birthday. Of these three, it's the only company still trading at growth-stock valuations. Bulls are hitching their wagon to Amazon.com's ability to expand its role as the premier online retailer, and its upside in the cloud-computing space.

The lesson of Wal-Mart, Microsoft, and Amazon.com? You don't need to immediately jump into the hot stock you just heard about. There's plenty of time to do your research first. See No. 1.

4. Avoid long shotsLynch claims he was 0-for-25 in investing in companies that had no revenue but a great story. Remember, the guy who averaged 29% returns went oh-fer on long shots. You and I are unlikely to do much better.

I've said it before, and I'll say it again. Use companies with proven track records as your baseline. ExxonMobil (NYSE: XOM) , IBM (NYSE: IBM) , and Procter & Gamble (NYSE: PG) are selling for 9, 11, and 16 times forward earnings, respectively. This is what the market is charging for solid, low-to-moderate-growth companies that dominate (or at least co-dominate) their spaces. Expect to pay more for higher-growth prospects, but make sure the risk-reward trade-off on an unproven company is worth it.

5. Good management is very important; good businesses matter moreThe pithier Lynchism is: "Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it."

For a prototypical example of a so-easy-a-caveman-could-run-it company, think the aforementioned Procter & Gamble.

6. Be flexible and humble, and learn from mistakesLynch has said: "In this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10."

7. Before you make a purchase, you should be able to explain why you're buyingSpecifically, you should be able to explain your thesis in three sentences or less. And in terms an 11-year-old could understand. Once this simply stated thesis starts breaking down, it's time to sell.

8. There's always something to worry about.Lynch noted that investors made a killing in the 1950s despite the very new threat of nuclear war. There are plenty of fears to choose from right now, but we've survived a Great Depression, two world wars, an oil crisis, and double-digit inflation.

Always remember, if our worst fears come true, there'll be a heck of a lot more to worry about than some stock market losses. Lynch's parting shot is that investing is more about stomach than brains.

Peter's principles in actionSo there you have it. These are the eight principles Peter Lynch used to bring the market to its knees. They seem simple, but trust me, sticking to them is harder than it sounds.

Our founders, Tom and David Gardner, seek to apply the lessons of the masters -- Lynch, Warren Buffett, et al. in their Stock Advisor newsletter. They take their time and look to identify those truly exceptional companies Peter Lynch talked about.

Tom's recommended Buffett's investment vehicle -- Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) . If you like Lynch's philosophy, you'll like Buffett's as well. In fact, I could have snagged a Buffett quote to support each of the eight principles above.

Meanwhile, David recommended the aforementioned Amazon.com back in 2002 -- in time for a 700% run-up. Both Berkshire and Amazon.com remain core recommendations, and David rates Amazon.com a "Best Buy Now."

If this kind of investing agrees with you, I invite you to join us and see all of David and Tom's recommendations. A 30-day trial is on us. Click here to start.

Comments from our Foolish Readers

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I Think its a good article. Timing is everthing though dollar cost averaging is also key.I recently purchased BRKB before split (10 shares),took half of that and put it in CVX.The one thing to do is buy stocks when the worst is upon us.Good Luck All!

Here's the difference- Peter Lynch operated in the luxury of a market that allowed for buy and hold. He didn't have to try and protect his position from massive volumes of electronic and naked short trades that wreak havoc with the market. He also operated in an era where there weren't any number of t.v. shows dissecting the market all day long giving the floor to any number of doomsayers whose words could cause massive selling to occur. So while his strategy for identifying a company may be applicable, buying and holding may not be as advisable in the markets of today. Sadly, the markets are not designed to protect individual investors. The SEC can't seem to protect us...hence, the new definition of SEC..."Securities..Except for Commoners"!

Good advice for individual stock market share holders but mutual fund owners are still left in the dark. I am still waiting for my fund manager to identify all my funds invested - in whole or part- in toxic mortgages or G-Sachs or AIG shares (I intend to rid my portfolio of such investments and encourage others to do the same)

I expect higher growth prospects or a lower price on companies whose business models aren't as predictable. For example, I use Procter & Gamble as an example b/c its brands (like Tide) don't need strokes of brilliance to be relevant 10 years from now. A company that relies on innovation does. For more, check out Buffett's ham sandwich quote about Coca-Cola:

Agreeing with RobMonaco...increased volatility, while nerve-wracking, is a boon to the patient, long-term investor. It helps us get in at good price points. That said, buy and hold still requires monitoring your companies for changes.

@bolob,

Not sure what to say on Wal-Mart...I rechecked and it does have a 20% return on equity...perhaps you're thinking of the stock price's return, which is different.

As for Microsoft, I didn't say it returned big in the last 10 years...I implied that you could have made a nice return even if you bought 10 years after it went public...that would mean buying somehwhere around March 1996...which would make it a multibagger in the 14 years since.

First of all, when he mentions 300 million people "each acting in their own self-interest", that number is just a little shy of our total population and millions of them are children and seniors who longer invest. A more accurate figure would be to quote our 100 million households who may have one investor per household and even then it's a stretch because there aren't that many Americans who invest in mutual funds. Secondly, that 29% return number -- whose number is that? Is it Lynch's, Fidelity's or an actual investor who has really earned a 29% return on funds invested with Lynch. I had an account with Fidelity for years and every statement shouted out a fabulous earnings number, but when calculating the per share price times the number of shares, my investment never grew at all and after several years I barely walked away with the amount I'd invested. What Fidelity did was constantly change the number of shares and share price to make it appear that my investment had increased. I've always felt Lynch's "genius" wasn't so much in the wisdom of his investments but in the creative statements they sent out to investors. His "genius" is vastly over-rated.

I think Anand referred directly to the US Economy, not the stock market when he cited 300 million people. And although you are right about actual investing decisionmakers, the economy is affected by the savings and spending habits of everyone. And anyone that has raised a child knows that spending by parents is dictated by both a child's needs and wants.

The financial press -- and MF -- love to recycle the same old "advice" pieces. They have a vested interest in perpetuating the Wall Street myth that to continually plow your hard-earned savings into the stock market will "always pay off in the long term / you can't time the market." Stop glorifying and pretending the bull market is still here, over a decade after it finished. The Dow has traded sideways for the last eleven years. T-bills would have been better than stocks, over that time. Before the great run of '82 to '99, the stock market was stagnant for an equally long time (and actually a loser, if you factor in inflation). There is no "growth story" happening in America, right now. All we export is jobs. Find another growth story for us, before preaching that our markets are destined to grow, or worse, recycling somebody else's sermon. THIS recycled piece about Peter Lynch, is tired and is a gyp. (Below is just one example of an earlier incarnation of this piece, replete with the Lynch quote about "any idiot.")

The article is poorly researched and only includes a catchy title. Why? Consider the following.

1) While Lynch was handed the Magellan fund in 1977, it was not open to the public before mid-1981. Before that it was the private investment vehicle for the Johnson family.

2) The S&P 500 is an imperfect benchmark for the Magellan Fund, particularly when Lynch took a risk in the later years and moved approximately 25% of the holdings into the international market. Using a customized benchmark, the results do not appear as stellar.

3) During his last four years, Lynch only outperformed the S&P 500 by 2% per year.

As William J. Bernstein writes in "The Intelligent Asset Allocator," and I quote, "As I'm writing this, more than a dozen domestic mutual funds have beaten the S&P 500 by more than 6% --Lynch's margin--during the past 10 years. This is about what you would expect from chance alone."

1. People are different. One person's investing principles may never work for someone with a different personality. If you are a person who can stick with these rules they will likely work. Donald Trump, on the other hand, uses the "file for bankruptcy every couple of years" strategy and it works even better...for him.

2. By recognizing what (to me) are obvious macro patterns in our economy (they are apparently impossible for Mr. Lynch to spot) I have taken advantage of undervalued and overvalued markets several times. Being out of and short the market just once in my lifetime (late 2007 to mid 2009) saved me more than Peter Lynch made in decades because it happened later in my life when I had much to save. Check back on this story in another 5 years and let's see what the story is. Peter Lynch would would have a very different story if he had been Japanese and started investing in 1990.

In summary, yes, Peter Lynch is a great investor but I know lots of geniuses from the 80' and 90's who are losing more and more as this new century wears on. Be critical and invest for your needs, not Peter Lynch's.

Absolutely! Except what if the worst is not for ten years? In the 1930's the stock market went down 90% for 3 years in Japan it is still on the decline 20 years later. What is the US market falls to 2,000 over the next ten years?

The worst appeared to be in the fall of 1929; it was not. The worst appeared to be in March of 2008, then July of 2008 and then in October and then in November and then in March and...bear markets suck you in and then chew you up and no two are ever alike.

I have ONE RULE for investing: wait for great values. If you believe this market offers great value you had better do your research.

This is another in the almost endless stream of articles by "experts" who are fond of pointing out that "If you had bought XYZ Corp. in 1986, you would have ..." without telling us just exactly how you would have, in 1986, chosen XYZ Corp. over ABC Corp., which had a similar rate of growth and return on equity (in 1986) but went bankrupt in 2002. As a couple of other commenters have pointed out, the market as a whole has gone nowhere for the last decade, and an investor would have been much better off putting his or her money in T-bills than in an S&P index fund. Some stocks have gone up during that decade, but I am still waiting for someone to tell us how, BASED ON WHAT YOU WOULD HAVE KNOWN THEN, you would have distinguished the stocks that were going to increase in value from those that weren't. Remember, any such advice would have to not only identify the "good" stocks, but distinguish them from the "bad" ones as well - at least more than 50% of the time.

Fellow fools, thank you all for all your M.F. comments about stock market investing. Making honest money one way or another is good for our economy. I enjoy this and other M.F. articles and am learning some "how to" things that I hope and pray will some day make me a millionaire like some of you are. We'll see. I read this to get amused, educated, and rich. Now that I have been amused and learned a little more, I must do my homework before investing to get rich. Someday I may be laughing (ha ha) all the way to the bank like you other fools. Cheers.

The point of the article is a great business will always provide a fair return and limit your risk. Their is no risk free investment other than Tbills or your Matress and neither will keep up with Inflation.

P.S. The Market has never had two straight decades of negative returns just some food for thought.

I'm a New Fool on the block, and I'm currently reading Lynch's "One Up On Wall Street." One thing he's somewhat adamant about is investing in a house before looking into stocks, etc. Does this hold true today, given the poor housing market and foreclosure epidemic? (Pretty sure I have an earlier edition of his book - 2003 or so.)

Because, dangit, I love my cute little apartment, and haven't had a rent increase in seven years.

This is short and sweet summary of the Peter Lynch method. I love Peter Lynch's insight on investing. I've used his strategy as the basis for my own foray into the stock market. I would never have picked Netflix back in 2004 without his advice. I've created a website in honour of his method for investing.